IRS Aims to Curb Workaround of Limit on Executive Pay Tax Break

Public companies would have a harder time evading a stricter limit on deductions for compensation paid to top executives under an IRS proposal.

The proposed regulations (REG-122180-18) implement a 2017 tax law provision that expanded the scope of tax code Section 162(m), which prevents public companies from getting a tax deduction for executive compensation exceeding $1 million. The rules target a workaround under which corporations could potentially skirt the limit by paying certain top executives part of their compensation through a partnership.

“What this does is it takes away the ability to plan around 162(m)” using that type of arrangement, said Eric Gonzaga, a partner and practice leader for Grant Thornton LLP’s Human Capital Services group in Minneapolis.

The Internal Revenue Service in private letter rulings issued between 2006 and 2008 said the $1 million deduction limit didn’t apply to the amounts company executives received from a partnership in which the company has an ownership interest for services performed for that partnership.

The IRS, however, stopped ruling on that issue in 2010 because it recognized the potential for abuse, the agency said in the Dec. 16 regulations. The rules make it clear that companies must now account for compensation their executives receive from such partnerships when determining the allowable deduction under Section 162(m).

Prior to the guidance some companies were considering whether the corporation-partnership scenario would work under the tax law changes, but it’s clear now that the IRS doesn’t look favorably on those arrangements, said Robert Delgado, the principal-in-charge of the Compensation and Benefits group of KPMG LLP’s Washington National Tax practice based in San Diego.

Hints From IRS

It isn’t necessarily a surprise to practitioners that the IRS took that stance.

The no-rule position for private letter rulings since 2010 was an indication of the agency’s thinking on the partnership issue, said Andrew C. Liazos, who heads the Executive Compensation Group and the Boston Employee Benefits Practice at McDermott Will & Emery.

In addition, “there have been statements informally from people at IRS for the last several months suggesting you may not want to be restructuring your business enterprises to try to create exemptions from 162(m),” he said.

The IRS provided transition relief for existing compensation arrangements, while also including language in the rules to prevent companies from using the partnership payment structure to sidestep the limit prior to the issuance of final rules.

Specifically, the agency said the new rule applies for taxable years ending on or after Dec. 20 but won’t apply to compensation paid pursuant to a written binding contract in effect on Dec. 20 that isn’t materially modified after that date.

“The Treasury Department and the IRS are aware that this issue has not been addressed in generally applicable guidance and understand taxpayers may have taken positions contrary to those set forth in these proposed regulations,” the IRS said.

The agency also requested comments on whether rules similar to the partnership rules should apply to trusts.